3 Reasons This Election is Ultra Important to Bond Investors

President Obama and Governor Romney have sharply different visions for tax policy, as well as different ideas on monetary policy and the size of government. Each of these differences could have a major impact on the bond market following the election.

1. Taxes On Investments

Romney is good for corporate bond prices and bad for municipal bond prices.

In 2013, taxes are scheduled to rise on ordinary income (bond interest) and dividends to over 43% for those in the highest tax bracket. President Obama supports these changes. If this went through, municipal bonds would rise in value. While on a first look this change would appear to be a negative for corporate bonds, assessing the impact is a little more complicated. Corporate bonds would be less attractive than municipal bonds on an after-tax basis, but more attractive than high dividend stocks for income investors.

Governor Romney wants to lower the tax on ordinary income to 25% and keep the dividend rate at the current level of 15%. Lower income taxes would make municipal bonds a less attractive investment compared to corporate bonds. In fact, lowering the tax rate on interest while keeping the tax rate on dividends the same, would make corporate bonds more attractive to investors currently buying high-dividend stocks

2. The Federal Reserve

The next president may have an opportunity to appoint 3 members to the Federal Reserve Board of Governors. The economic advisers surrounding Romney would indicate that he would pick inflation hawks to fill the vacancies at the FED. These new Fed Governors might favor raising short-term interest rates prior to the end of 2014. Currently, the FED has indicated that it will keep short-term rates close to zero until the end of 2014. Obama’s picks will probably favor keeping rates low.

3. The Government Debt

Obama is likely to have standoff over the debt ceiling with Congress, causing Treasury Market volatility.

The US Government Debt currently stands at around $15.6 Trillion. The legal debt limit, the maximum that the federal government can borrow, stands at $16.4 billion. This limit will be hit sometime in the next 5 to 8 months, right around the elections. The last time the government approached the debt limit, there was major partisan fighting between Republicans and Democrats. This fighting lead to S&P cutting the US Government’s credit rating from AAA to AA+ and played havoc on the markets.

If the government hits the debt limit, non-essential parts of the federal government must shut-down. I think it is highly unlikely that either party will want to shut-down the government prior to an election. Instead, they will “kick the can down the road” for six months to a year, putting the issue in the hands of the next elected president.

If Obama is elected President, particularly in a close election, we might have a replay of the last standoff. If that happens treasury volatility might increase and short term yields rise.

If Romney is elected President, the Republican controlled House and Senate, will probably not want to embarrass the new President. An increase in the debt ceiling without a lot of drama would therefore be a likely outcome.